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Friday, August 31, 2012

Michael Woodford, arguably the top monetary economist in the world, endorsed nominal GDP level targeting today at the Jackson Hole Economic Symposium. He did so as part of a broader critique of the Fed's monetary policy over the past four years. Among other things, he makes the following points in his critique:

(1) Quantitative Easing has not been very effective because the increase in monetary base it created is not expected to be permanent. If it were expected to be permanent, then the future price level and nominal income level would also be expected to permanently increase. Households and firms would respond to this development by increasing nominal spending today. The key point is to communicate some part of the monetary base increase will be permanent. See Bill Woolsey for more on this issue.

(2) The forward guidance provided by the Fed on the expected path of the target federal funds rate is doing little-to-nothing to restore robust economic growth. When the Fed lowers the expected path of the policy interest rate in its forecast is it because the Fed is truly adding monetary stimulus or is it because the Fed now expects a weaker economy? In the latter case, the Fed would be seen as simply maintaining the status quo of weak, anemic growth. See here for more on this point.

(3) Large scale asset purchases have not been effective in driving down long-term interest rates. If anything, it is the weak economy that explains most of the decline in yields. Exactly. While there are long-term structural changes (e.g.. aging, saving preferences in Asia, lower expected productivity growth) that may explain some of the decline, the fact that over the span of the crisis the 10-year treasury yield has gone from above 5.1% to 1.6% suggests a cyclical story. Simply, the ongoing expectation of weak economic growth in advanced economies is pushing down yields. The irony here is that the Fed, through its influence on global monetary conditions, could change economic expectations for advanced economies and raise long-term yields. In a sense, then, the Fed is responsible for the low interest rates just not in the way most observers think.

Woodford sees a nominal GDP level target that returns nominal GDP to a pre-crisis trend path as the best way forward for the Fed. It implemented properly, this approach would not be susceptible to the above critiques. Here is Woodford:

An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.

He even invokes the now-popular NGDP-below-trend figure to show that NGDP is 10-15% below where it should be. By implication, then, Woodford is accusing the Fed of effectively keeping monetary policy too tight since late 2008. There is far more to the article, but how refreshing it is to see someone of Michael Woodford's stature to endorse what Market Monetarists have been saying for the past four years. Moreover, it adds to the growingmomentum for monetary regime change at the Fed.

P.S. No mention of Market Monetarism and the influence it has had in promoting NGDP level targeting, but that is okay (though footnote 33 was a pleasant surprise). What matters more is to minimize that vast amount of human suffering being caused by tight monetary policy. Woodford's article pushes us one step closer to that goal.

Thursday, August 23, 2012

I have made the case many times that the Federal Reserve is a monetary superpower. The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies becomes too expensive relative to these dollar-pegged currencies and the dollar itself. U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well.

This understanding helps explains why there was a global liquidity glut during housing boom period and suggests that some of the "global saving glut" was simply a recycling of loose U.S. monetary policy. It also implies that the Fed could now do a lot of good for both the U.S. and Eurozone economies if were to adopt something like a NGDP level target. Based on this view, the global economy sorely needs the Fed to wake up from its slumber. Fed Chairman Ben Bernanke admitted as much in one of his classroom lectures earlier this year.1

Chris Crowe and I developed this monetary superpower hypothesis in a paper that is now in my newly published book. In a new paper, Colin Gray has gone even further by formally motivating this hypothesis in a rational expectations model. He also has provided more robust empirical evidence for it. Here is his abstract:

Between 2002 and 2006, the United States Federal Reserve set interest rates significantly below the rates suggested by well-known monetary policy rules. There is a growing body of research suggesting that this helped fuel an excess of liquidity in the U.S. that contributed to the 2008 worldwide financial crash. What is less well known is that a number of other central banks also lowered interest rates during this period. An important question, then, is what role the Federal Reserve played in influencing other central banks to alter their own monetary policies, which could have magnified the Fed’s actions in creating global liquidity. This paper addresses the issue by showing how spillovers in central bank behavior occur in theoretical rational expectations models. It then establishes empirically how U.S. monetary policy actions affect the actions of other major central banks, particularly in terms of interest rates and currency interventions. The data suggest that the U.S. lowering its policy rate, in general or in reference to a specific monetary policy rule, influences other central banks to lower their own policy rates and intervene in currency markets, even when controlling for worldwide macroeconomic trends. Finally, this paper shows that spillovers from U.S. actions are partially responsible for the worldwide lowering of interest rates and the increase in currency reserves in the early 2000’s that may have contributed to the subsequent worldwide liquidity boom.

The findings of this paper deserve further discussion. In particular, how should the Fed operate given it has this monetary superpower status? Is there a way to do U.S. monetary policy that maximizes macroeconomic stability for both the United States and the rest of the world? These are important questions that will become more important over time as the global economy continues to integrate.

1Okay, he really did not admit it, but it was implied in his acknowledgement that Chinese monetary policy is influenced by U.S. monetary policy.

The Independent Institute has published a new book that every thoughtful Fed watcher should read. It makes the case that rather than dampening the business cycle over the past decade the Fed has actually amplified it. The book consists of essays from a number of economists and has something for everyone. Austrians will like that the book argues the Fed enabled the housing boom, while those sympathetic to the Market Monetarist view will appreciate its claim that the Great Recession was the result of too tight monetary policy. Advocates of MMR and MMT will appreciate the book's critique of the procyclical financial system and its suggestions for reform. As I said, something for everyone.

Here are first few paragraphs of the introductory chapter:

In 2009 the entire world economy stopped growing, the first time this had happened in well over 50 years. In the United States, the epi-center of the great recession, GDP shrank, unemployment rates skyrocketed, and budget deficits exploded. The 21st century had opened with optimism as first technology and then housing boomed, but by the end of the decade confidence had been drained. Why did the boom and bust cycle return in such force after several decades of economic stability? Most studies answer this question by pointing to financial innovation, a global saving glut, poor governance, industry structure, housing policy, and misaligned creditor incentives. Though these areas are an important part of the story, the amount of attention given to them makes it easy to ignore the errors of perhaps the single most powerful actor in the world economy today, the U.S. Federal Reserve. The chapters in this book offer some much needed perspective by shifting the focus back to the Federal Reserve. These essays conclude that the wide swings in the economic activity could not have occurred without the destabilizing policies of the Federal Reserve.

Former Federal Reserve Chairman William McChesney Martin once famously quipped that it was the central bank’s job to take away the punch bowl just as the party is getting good. The essays in this book show that rather than follow this advice, the Federal Reserve spiked the punch bowl and then kicked the hung-over economy out to the street at the worst possible time. Monetary policy was strengthening the business cycle instead of leaning against it during the 2000s.

The context for this “leaning with the wind” rather than against it by the Federal Reserve begins with the expansion that followed the 2001 recession. Though centered on housing, this expansion grew and pulled in many different parties including builders, subprime borrowers, mortgage originators, investment bankers, rating agencies, and investors from around the world. It also elevated the importance of structured finance and the shadow banking system. The pace of the expansion accelerated and soon it became the Great Boom of the 2000s. Like other big booms before, it was characterized by excessive leverage, mispricing of risk, soaring asset prices, and a pervasive “it’s different this time” optimism. By 2007, however, the Great Boom had ended. It was soon followed by financial stress and the beginning of what was initially a mild recession. By late 2008 the financial stress had turned into a severe financial crisis that froze up credit markets and led to a sharp decline in the stock market. Similarly, by late 2008 the mild recession had mutated into one of the sharpest economic downturns since the Great Depression. This Great Recession was characterized by a dramatic collapse in spending and double digit unemployment.

Chapters by Lawrence H. White, David Beckworth, Diego Espinosa, and Chris Crowe show that the leaning with the wind began when the Federal Reserve failed to tighten monetary policy sooner in the 2002-2004 period. The economic recovery was well underway by that time and yet monetary policy remained extremely accommodative throughout this period. As a result, the recovery that followed the 2001 recession got turned into the Great Boom. Chapters by Scott Sumner, Jeffrey Rogers Hummel, Bill Woolsey, and Nick Rowe show that when the economy began contracting in 2008 the Federal Reserve once again leaned with the wind by effectively tightening monetary policy. This response turned what was initially a mild recession into the Great Recession.

Going forward, what can be done to avoid repeating these monetary policy mistakes? Chapters by Joshua Hendrickson, William R. White, Lawrence Kotlikoff, and George Selgin address this question. They acknowledge as a starting point that monetary policy should a better job stabilizing nominal spending in a rule-based fashion. Several chapters even make the case for a nominal income targeting rule. One implication of these chapters is that had the Federal Reserve been stabilizing nominal spending the Great Boom and the Great Recession of the 2000s may have never happened. Other chapters, however, question if stabilizing nominal spending is enough or if it is even possible given our current institutional arrangements for monetary policy. These essays, therefore, call for other reforms that aim to reduce the procyclical tendencies of the financial system while other chapters call for alternative monetary institutional arrangements altogether. Given the ongoing interest in reforming the Federal Reserve, these chapters provide a good starting point for considering how to do it and more generally how to maintain macroeconomic stability.

Friday, August 10, 2012

Should the Fed lower the interest on excess reserves (IOER) to help stimulate the economy? Cardiff Garcia of FT Alphaville and I recently discussed this question. He made the case that lowering the IOER is likely to severely disrupt short-term financial intermediation, particularly money market funds (MMFs), and its benefits are not clear. I countered that with the right signalling the Fed could meaningful add monetary stimulus by lowering IOER without disrupting MMFs. Garcia responded by questioning whether the Fed could really deliver what I claimed and to this point I replied here.

Now it is Dan Carrol's turn. He says not so fast Garcia and provides counterarguments. Let me add to Carrol's points that the Treasury is now gearing up to handle negative interest rate bidding. Bloomberg reports the following:

The Treasury also said it is “in the process of building the operational capabilities to allow for negative-rate bidding in Treasury bill auctions, should we make the determination to allow such bidding in the future.”

Now go read Carrol's critique of Garcia's assessment. I have also posted his remarks below the fold.

Thursday, August 9, 2012

Does economic uncertainty matter? Yes, says Stanford professor Nicholas Bloom, University of Chicago professor Steven Davis, and Stanford grad student Scott Baker in a new paper titled Measuring Economic Uncertainty. They find that economic uncertainty caused real GDP to decline 3.2% over the past few years. This paper has stirred controversy because it has been used by conservatives to show that uncertainty created by President Obama is the main reason for the ongoing slump. Some observers like Mike Konczal, Dylan Matthews, and Matt O'Brien have questioned the use of this index on methodological grounds as well as on its proper interpretation. The latter point is really important. While there can be exogenous shocks to uncertainty such as the debt ceiling talks last year, uncertainty is always with us and is endogenous to the the state of the economy.1 That is, people get more uncertain the weaker the economy becomes and vice versa.

Here are some figures that illustrate this point. The first one shows a 3-quarter centered moving average of the paper's uncertainty index along with the nominal GDP (NGDP) gap. This gap measures aggregate demand deficiency and is calculated as the percent difference between potential and actual NGDP:

The two series are clearly related. The next figure shows the strength of this relationship:

This scatterplot does not establish causality, but it does suggest that about two thirds of economic uncertainty can be traced to a shortage of aggregate demand. Mike Konzcal might argue the relationship would be even stronger if not for the measurement problems. Even so, this is still a strong relationship and implies that Fed could do far more to spur a recovery by closing the NGDP gap.

Even if one believes causality runs form greater uncertainty to lower NGDP, the Fed still should respond. For the reason greater uncertainty matters is that is raises money demand which, for a given stock of money assets, causes a slump in nominal spending. The Fed could ease uncertainty and the resulting money demand by committing to a NGDP level target. This would close the NGDP gap and add certainty to the future path of nominal incomes. The failure of the Fed to do this means the economic uncertainty is as much a byproduct of the Fed's inaction (i.e. passive tightening) as it is anything else.

1Even the debt ceiling crisis to some extent was endogenous. For had there been no Great Recession, both cyclical and structural budget deficits would have been much smaller.

Tuesday, August 7, 2012

Or at least James Pethokoukis of the AEI does. He has been blogging like a Market Monetarist of late. Here he makes the case the Fed caused the Great Recession, not the housing bust or oil shock. Here James is considering whether it is time for the Fed to launch a pro-growth monetary policy. Finally, he pushes the argument here that the Eurozone crisis is a nominal GDP crisis, not a debt crisis. This is encouraging since most of the right-of-center think tanks have been overrun by the gold bug.

Market Monetarists have long championed the Chuck Norris approach to central banking. That is, the Fed should explicitly adopt a Nominal GDP (NGDP) level target and use this target to better manage nominal spending expectations. Doing so would catalyze the public into changing their current spending and investment decisions toward more nominal expenditures. In other words, it would incentivize the public to do the heavy lifting in sparking a robust recovery. To make this credible, the Fed would have to commit to purchasing as many assets as necessary to hit its target. Such open-ended QEs would be a vast improvement over the current make-it-up-as-we-go-along, incremental approach to QE.

This idea is now gaining traction at the Fed. San Francisco Fed President John Williams first endorsed it a few weeks ago. Now, Boston Fed Presdient Eric Rosengren has come out in favor of it (my bold):

Eric S. Rosengren, president of the Federal Reserve Bank of Boston, said
that the Fed should again expand its holdings of mortgage bonds and
Treasury securities, and that the purchases should steadily continue
until the Fed was satisfied with the health of the economy.

[...]

Mr. Rosengren’s proposal for new action would be a significant shift
from earlier rounds of asset purchases, when the Fed announced in
advance how much money it would spend and over what period of time. Mr.
Rosengren and other officials, including John C. Williams, president of
the Federal Reserve Bank of San Francisco, say that the focus instead
should be on results.

[...]

Mr. Rosengren said he did not have a firm view on what kind of measuring
stick the Fed should use for a new program of asset purchases. But he
suggested the Fed could target a minimum rate of nominal growth —
economic growth plus inflation — of 4.5 percent. The government
estimates the rate of nominal growth in the 2012 second quarter at 3.1
percent.

Now Rosengren is not a voting member this year at the FOMC, but his views in conjunction with those of John Williams show how the thinking at the Fed is changing. Ben Bernanke the academic who studied Japan would certainly be sympathetic to this view. Throw in Janet Yellen along with a few more Williams and Rosengrens and there may be some serious momentum for open-ended QE. All the efforts of the blogosphere may yet payoff. [Update: I forgot that Chicago Fed President Charles Evans was the first Fed official to officially endorse NGDP level targeting.]

P.S. By adopting a NGDP level target the Fed would not unmoore long-term inflation expectations. A NGDP level target would, though, be solving an excessmoney demand problem created by a shortage of safe assets.

Friday, August 3, 2012

One of the FOMC's more recent policy innovations is Operation Twist. Initiated last September, this program aims to shrink the average maturity of publicly-held U.S. Treasury debt and thereby encourage a rebalancing of private portfolios toward riskier assets. This rebalancing, in turn, would help spur a recovery in aggregate nominal expenditures via balance sheet and wealth effects. At least that is how it is suppose to work.

There are, however, two big problems with this initiative. First, it has not been accompanied by an explicit economic target and therefore does little to improve nominal spending expectations. Second, it has been countered by the U.S. Treasury which is increasing the average maturity of publicly-held debt. This can be seen in the figure below which comes from a recent U.S. Treasury report:

Not only has the Fed been failing to lower the average maturity, but it faces a U.S. Treasury determined to continue raising it as seen by the green forecast line. Below is another figure from the report that shows the actual and forecasted shares of different types of treasuries publicly held. Again, it is evident that longer-term treasuries will continue to grow in importance:

Now Operation Twist has not been completely futile. By swapping its short-term treasuries to the public in exchange for their long-term treasuries, the Fed has forced the U.S. Treasury to face unexpected financing costs. Operation Twist has and is placing in the public's hands treasuries that are are coming due sooner than their previously-held long-term treasuries. This means the U.S. Treasury will have to pay the public sooner than it had planned. Here is another figure from the report that shows how much these additional payments will be through 2016:

Yep, that is an additional $667 billion the U.S. Treasury was not expecting to have to cough up over the next four years. To be clear, this is not an adding to the total stock of debt, but is pulling forward the payment date of publicly held debt.

So how will the U.S. Treasury pay for it? By rolling over the debt of course. And not just any new debt, but a special new kind of floating rate note that will come out in a year. Gregg Robb reports that industry experts say there will be “strong, broad-based demand” for the floating-rate notes and that their interest rates will not be tied to Libor. I am sure John Cochrane is happy about the latter point, but it is still not clear to what they will be tied.

This is an interesting case of monetary and fiscal policy colliding and creating unintended consequences. It is also an illustration of why the Fed should have been doing open-ended QEs tied to a nominal GDP level target instead of its current piecemeal approach of which Operation Twist is a part. For had the Fed done open-ended QEs, it would have sent a jolt to public expectations and catalzyed a broad-based recovery where the market did most of the heavy lifting. The Fed would not have needed to resort to vast asset purchases and consequently there would be fewer treasury market distortions. In other words, most of these developments could have been avoided had the Fed taken the Chuck Norris approach to central banking.

Thursday, August 2, 2012

The two major central banks of the world demonstrated this week they are fine watching the global economy go over the cliff. Yesterday, it was the Fed. Today, it was the ECB's turn. Their failure to act in the midst of the ongoing crisis amounts to a passive tightening of global monetary policy. This is because their inaction raises the global demand for safe assets while allowing existing ones to be destroyed. Since these safe assets effectively act as money, the central banks are worsening the excess money demand problem that underlies the global aggregate demand shortfall. This passive tightening has been going since mid-2008 and confirms that we are witnessing what Ryan Avent calls the epicfailure of central banking. Future historians will not be kind to these central banks.

Wednesday, August 1, 2012

The FOMC continues to disappoint. Other than acknowledging the economy is getting worse, the FOMC decided to sit on its hands and hope the aggregate demand slump disappears on its own. As I have noted before, this failure to act by the Fed when money demand is elevated and growing amounts to a passive tightening of monetary policy. Caroline Baum in her latest Bloomberg column agrees. Can anyone say Lords of Finance 2.0?

I have been disappointed for so long that sometimes I feel the need to believe in parallel universes where somewhere out there a FOMC actually does its job. In that universe, the FOMC responds forcefully to the aggregate demand slump and does so using a nominal GDP level target. Below is what the FOMC statement in that parallel universe would look like. (It is an update on a similar post I did for the April FOMC. I plan to update and post it every FOMC meeting the Fed fails to do its job.)

Release Date: August 1, 2012

For immediate release

Information received since the Federal Open Market Committee met in June suggests that economic growth remains anemic. Labor market
conditions are weakening and the unemployment rate continues to remain
elevated. Household spending and business fixed investment appears to
be slowing down. Inflation has moderated in recent months. Long-term
inflation expectations remain well anchored.

Consistent with its statutory mandate, the Committee seeks to foster
maximum employment and price stability. The Committee continues to
expect a sluggish pace of economic growth over coming quarters as the
crisis in Europe, the slowdown in Asia, and the uncertainty over
year-end fiscal austerity plans are creating significant headwinds for
the economy. These developments along with the economy operating below
its full-employment level indicates that further action is warranted by
the Committee.

To support a stronger economic recovery and to help ensure that
inflation, over time, is at levels consistent with the dual mandate, the
Committee decided today to begin a new conditional asset purchasing
program tied to an explicit growth path for nominal GDP. The Committee
believes that nominal GDP should expand to $16 trillion dollars and grow
at a 5% annual pace thereafter. To this end, the Committee intends to
purchase Treasury and Agency securities every week until this target is
hit.

This program should raise expectations of future nominal GDP growth and
cause a rebalancing of portfolios that will facilitate a rise in current
aggregate nominal spending. The Committee will regularly review the
size and composition of its securities holdings and is prepared to
adjust those holdings as appropriate.

The Committee also decided to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.